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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
A View from Inside the SEC:
Remarks at the Financial Service Institute's 2006 Broker-Dealer Conference


Commissioner Cynthia A. Glassman

U.S. Securities and Exchange Commission

San Diego, California
January 25, 2006

Good Morning. I appreciate the opportunity to speak at the wrap up session of what looks like a very comprehensive conference. When Dale Brown invited me to speak, he asked that I share with you my view from inside the Commission and that I help you understand the SEC's priorities and focus for the coming year. He also suggested that I provide you guidance on creating a good relationship with the SEC. That's a lot of ground to cover, but I'll try to touch on the issues most relevant to you. In this regard, now is a good time for me to give the Commission's standard disclaimer that the views I express today are my own, and do not necessarily reflect the views of the Commission or its staff.

I note with some amazement that in three days it will be my fourth anniversary as a Commissioner. This period has gone by so quickly. Little did I realize when I was appointed by President Bush in 2002 that I was about to enter one of the agency's most challenging times in its 72 year history. Just six months after my appointment, Congress enacted the Sarbanes-Oxley Act, which was passed in response to the corporate scandals at Enron, Worldcom, and others. This unleashed a torrent of rulemaking activity that has finally abated. The following year brought to light the market timing and late trading scandal associated with a number of mutual fund families and their advisers. As a result of that activity, the SEC engaged in another series of rulemakings designed to bolster the compliance and oversight in that industry and initiated numerous enforcement actions against market timers, late traders, and the funds and advisers that enabled this activity. During this period of unprecedented activity, I have served with three chairmen, not including my own stint as Acting Chairman of the Commission last summer, and voted on numerous proposed and final rules and thousands of enforcement recommendations.

In fulfilling my duties as a Commissioner, I believe it is imperative that the agency remains focused on its mission of protecting investors and maintaining fair, orderly, and efficient markets when we adopt new rules and enforce the securities laws. I believe we should be clear on what our objectives are and try to accomplish those objectives efficiently and effectively. In particular, I have been and remain concerned that we perform a meaningful cost/benefit analysis prior to the adoption of any rule to ensure, as best we can, that the benefits of a proposed agency action justify the costs. My focus on the costs and benefits arises from my background as an economist, which puts me in the minority at an agency comprised largely of attorneys and accountants. Further, as an economist, my philosophical preference is for market, rather than regulatory, solutions whenever possible, although I do believe regulations are appropriate when the market is not working. In that vein, clear disclosure and transparency are critical to providing the information needed by the market to work effectively.

Regarding the SEC's priorities and focus for the coming year, there are two issues on the SEC's agenda that are particularly relevant to this audience. The first involves our recently adopted rule regarding certain broker-dealers deemed not to be investment advisers. As I am sure all of you are intimately aware, subject to certain exceptions and conditioned on the provision of certain disclosures, this rule permits broker-dealers to offer fee-based accounts without having to register under the Advisers Act. Where the broker-dealer is already registered as an adviser, it allows the broker-dealer to offer fee-based accounts without treating them as advisory accounts.

Permitting broker-dealers to offer fee-based accounts without having to comply with the requirements of the Advisers Act has raised issues because broker-dealers and investment advisers operate under different regulatory regimes. Generally, broker-dealers are subject to a suitability requirement; that is, recommendations that brokers make must be suitable for the customer. In fulfilling this obligation, broker-dealers may, but frequently do not, owe their customers the fiduciary duties of loyalty such that they are required to make upfront disclosure of each and every conflict. On the other hand, investment advisers are always fiduciaries that owe their clients a variety of fiduciary duties, including the duty to disclose conflicts of interest in advance of recommending a transaction and a duty to put the investor's interests first.

As we acknowledged in the adopting release, the line between full-service broker-dealers and investment advisers continues to blur. This blurring was confirmed by the results of our focus group testing of proposed disclosure language about the differences. The testing, performed through our Office of Investor Education and Assistance, demonstrated that while the customer disclosure language, as originally proposed, was successful in alerting investors to the need to ask questions about the differences between brokerage and advisory accounts, the proposed language did not actually answer the investors' questions. Rather, the focus group results indicated that investors did not appreciate the distinctions among various financial professionals and that many appeared to believe that anyone with a title other than broker - including "financial advisor" or "financial consultant" - was something more than a broker.

Although the final rule has been adopted, it has not yet been fully implemented. At the request of the FSI and others, the Commission extended the compliance date for its complete implementation until the end of this month. Further, when the Commission adopted the rule last April, we recognized the need for a broader study of the levels of protection afforded retail customers under the Exchange Act and the Advisers Act and ways to address investor protection concerns arising from differences between the two regulatory regimes. In other words, given how the world has changed in the decades since the Exchange Act and the Advisers Act were enacted, does it any longer make sense to have two separate regulatory schemes for substantially similar activities? As we explained in the release, these are the types of questions that the study would address:

  • Should the Commission seek legislation that would integrate the existing regulatory schemes applicable to broker-dealers and investment advisers that provide services to retail clients?
  • Should sales practice standards and advertising rules applicable to advice provided by broker-dealers be enhanced?
  • Should broker-dealers who provide investment advice but who are excepted from the Investment Advisers Act nonetheless be subject to the fiduciary obligations imposed by that Act on investment advisers?
  • Should obligations under the Investment Advisers Act applicable to dually-registered broker-dealers be modified or streamlined in order to eliminate regulatory overlap and reduce regulatory burdens?
  • Are there areas in which the Commission, alone or in concert with other agencies, can engage in investor education efforts to assist investors to better understand the duties and obligations of their financial service providers?

The study will be very important in helping us to answer these questions, and we need to focus on it as quickly as possible.

The second issue on the Commission's radar screen is the proposed "point of sale" disclosure form for mutual funds (as well as variable annuities and 529 plans) sold by broker-dealers. This was proposed in January 2004 to enhance the information that broker-dealers provide to their customers before they buy, so that customers understand what it is that they are paying for and whether the broker has any conflicts of interest relating to the sale.

To learn whether our proposed disclosure got the message across to real investors (not just to lawyers), we launched a major outreach program to get comments from real investors. As part of that program, the Commission, through our Office of Investor Ed, hired a consultant to conduct focus group testing in various cities. I cannot emphasize strongly enough how important the focus group testing proved to be. By testing various versions of the forms we learned that the original drafts did not work as well as we had hoped. Using those findings, we revised the forms and sought additional comment.

We continue to evaluate comments on the disclosure forms based on what the investor focus groups found most useful, and we may seek further comments. We also will take into consideration the comments we have received from the industry, both from broker-dealers and mutual funds, in order to achieve a final rule that is cost effective in accomplishing its objective. I also anticipate helpful insight from a study currently underway by the Consumer Federation of America, with a grant from the NASD Foundation, to identify the knowledge level that investors require in order to make sound mutual fund investment decisions and the manner in which consumers desire to receive information about mutual fund products.

I have saved as the last topic Dale's request for guidance on creating a good relationship with the SEC. Frankly, a good relationship with the SEC is ancillary to the real issue, which is creating a good relationship with your customers. Obviously, being honest and ethical is a requirement of any good relationship. Another requirement is addressing conflicts of interest, which we all realize exist in your business. On the one hand, you want to help your customers achieve their financial goals. On the other hand, you are entitled to be compensated for your services. These competing goals create the potential for your financial incentives to conflict with those of your customer.

What I would ask is that you think about how you would like your grandmother to be treated. Then think about how you would feel if your activities were chronicled on the front page of your local newspaper. And then think about how you would feel if your grandmother read that article. If any of these thoughts make you uncomfortable, what does that say about your integrity and your willingness to disclose information that the customers need in order to make good decisions? Disclosure of all relevant information to your customers is a key component of a successful relationship and a blemish-free career. Communication with your customers that is clear, understandable, and uses plain language is important to your success. This means that you must strive to meet not just the letter, but the spirit of the securities laws, which have as their guiding principle disclosure of material information. Let me elaborate with some real-life examples to illustrate my point.

To prepare my remarks today, I examined enforcement actions that the agency initiated in its 2005 fiscal year against brokers to see what lessons could be learned. This examination was enlightening. Of the 629 enforcement actions initiated in fiscal year 2005, 94 actions (15%) were filed against broker-dealers. The alleged violations in these actions varied across the board, but certain violations tended to recur. For instance, a number of registered representatives were alleged to have fraudulently used their firm's systems to enter market timing or late trading orders on behalf of themselves or their customers. Others were charged with misappropriating customer funds and sending sham account statements. Another group purportedly made unauthorized purchases or transfers for customer accounts.

Obviously, these and other practices that are outright fraudulent violate the securities laws and are unacceptable to your customers, to your firms, to us, to the criminal authorities, and - I hope - to your grandmother. But there are other cases where a broker engages in conduct that is not per se illegal, but the broker violates the securities laws because of failure to disclose to customers necessary information about its conduct. An example of this conduct is the $75 million settlement by the Commission, the NASD, and the New York Stock Exchange a little more than a year ago with Edward D. Jones & Co. based on that broker-dealer's failure to disclose adequately to its customers that it received revenue sharing payments from a select group of mutual fund families that the firm recommended to customers. The revenue sharing payments created a conflict of interest for the firm. The failure to disclose that conflict violated the securities laws by denying investors material information regarding the full nature and extent of any conflict that may affect the transactions that the firm recommended to them.

Another example is the Commission and NASD's settlement in 2004 with 15 broker-dealer firms that failed to deliver mutual fund breakpoint discounts to their customers. The settlement came about as a result of the NASD's directing securities firms to conduct an assessment of their mutual fund transactions using a statistically significant sample of transactions in 2001 and 2002. The assessments showed that most firms did not uniformly deliver breakpoint discounts to customers and that, overall, discounts were not delivered in about one of five eligible transactions. The 15 firms in the settlement were named in the enforcement actions because they either had significantly higher than average failure rates or, if not significantly higher, then higher than average failure rates combined with high dollar amounts of total overcharges.

In settling with the broker-dealers, the Commission recognized that because of the large number of mutual funds offering different discounts and employing different criteria, broker-dealers faced operational and other challenges in assuring that their customers consistently received the applicable discounts. Nonetheless, each broker-dealer was responsible for exercising due care, based on information reasonably ascertainable by the broker-dealer, to provide the appropriate breakpoint discounts. As a result, the Commission found that the settling broker-dealers committed violations in offering and selling the mutual funds to their customers. The Commission also found that all but one of the broker-dealers failed to provide customers with written notice of the remuneration the broker-dealers received from front-end sales loads.

Although the broker-dealers in the Edward Jones and breakpoint discount cases settled without admitting or denying the violations, had the broker-dealers disclosed clearly the relevant information, the enforcement actions would not have been necessary in the first place - and the broker-dealers definitely would have a better relationship with the SEC.

In addition to reviewing enforcement cases, I also reviewed Commission complaint data in preparation for this speech. You may not be aware of it, but the SEC, through its Office of Investor Ed, compiles annual data on the number of investor complaints, questions and other contacts that the agency receives. For the agency's fiscal year 2005 that ended September 30, 2005, the SEC received more complaints about broker-dealers (approximately 31% of all complaints) than any other type of entity, including issuers, mutual fund companies, investment advisers, and transfer agents. This is a sobering statistic. Unfortunately, it is not an anomaly but rather is consistent with complaint data from earlier years.

What I would like to do now is talk about the top five types of complaints against broker-dealers, and what you can do to minimize or avoid them and thereby avoid problems. The largest category of complaints (622) involves transfer of account problems. This is a continuing problem and in fact it increased from 2004 to 2005. An example is where a customer has an investment in a proprietary fund, changes brokerage firms, and the proprietary fund cannot be transferred into an account at the new firm. The reasons for changing firms varies, but typically include that the broker has moved to a new firm and the customer would like to follow or where the customer has been solicited by a new broker to open an account. When the customer finds out that the attempted transfer has problems, the customer becomes unhappy. If this unhappiness is not resolved, the customer complains to the SEC. If you the broker (whether at the old firm or the new firm) take the time upfront, when the initial account transfer request is made, to analyze the customer's existing account and the difficulties that may arise from transferring it, you can inform your customer of the anticipated problems and options to deal with them. In other words, you can manage your customer's expectations. Clear communication, in plain understandable language rather than securities jargon, is essential to reducing or avoiding this otherwise predictable complaint.

The second largest category of complaints (533) involves unauthorized transactions. The problem here is that the transgression is largely in the eye of the beholder. For example, the customer complains that the broker was not given permission to execute a trade in the account. In those situations where the broker in fact is executing trades without authority, obviously the customer has a valid complaint. However, more often than not, it is a margin account, and the broker is acting within its authority to sell securities to cover a margin call. The real issue here is that the customer doesn't understand the practical ramifications of a margin account. This type of problem is made more likely if a margin account was opened for the customer by default without the customer understanding or appreciating either the nature of that type of account or that the broker would have the ability to execute transactions to cover margin calls. Once again, the solution is to provide the customer with clear communication upfront, so that the customer understands the rights and obligations that exist between the two of you. It is somewhat encouraging that this category of complaint has dropped in frequency from 2004 when it was the number one investor complaint against brokers.

The third category involves account closing complaints (518), including problems with redemptions or liquidations. This is a growing complaint (it was number five in 2004) and evidences a troubling trend that defies ready explanation. It is possible that part of the problem is due to back-end fees (such as early B share redemptions) or large surrender charges (associated with variable annuity account holders) that the customer incurs without understanding, prior to the imposition of these charges, that he or she would be liable for them. At the risk of sounding like a broken record, I must again point out that many of these complaints can be avoided if the broker would provide the customer with clear communication upfront, so that the customer understands the back-end fees or surrender charges that will result in the event the account is closed.

Complaint category four involves problems with account records (433), specifically customer statement errors or omissions. What I hear is that often it is extremely difficult for customers to decode their statements. The statements themselves might not have any errors or omissions, but if the customers do not understand the information in the statements, they conclude that the statements are somehow deficient. Once again, many of these complaints could be easily avoided if the brokers take the time necessary to explain to their customers the information contained in the statements.

The last complaint category involves unsuitable recommendations (395). Not surprisingly, the frequency of this complaint is inversely proportional to market performance. When the market is up, the total number for this complaint category is down and vice versa. Realistically, except for those situations where the broker is indeed making unsuitable recommendations, there is not much you can do to prevent these types of complaints from being raised. However, you can and should protect yourself against unfounded complaints by maintaining accurate records consistent with your compliance obligations.

In reviewing our enforcement actions initiated and the most frequent complaints received in the past year, what quickly becomes obvious is that, in many situations, the number of enforcement actions or complaints could have been drastically reduced had the brokers taken more time to educate their customers and keep them informed through clear disclosure and communications. To reiterate the "grandmother test," if you do what is right for the customer and provide what the customer needs to know in order to make an informed decision, that should certainly help you create a good relationship with the SEC.

Thank you. I am happy to answer any questions.


Modified: 01/26/2006